Wednesday, June 18, 2014

Valeant Pharmaceuticals Part VII: First notes on the special conference call

Valeant Pharmaceuticals yesterday held its "facts-based" conference call. There were plausible denials of several things that have been suggested in this blog and one flat acceptance.

The first observation is that Valeant's CEO Mike Pearson and I agree on the basic accounting issue at Valeant. [We have different views on the end-result.]

At the moment Valeant is loss making and if you look at their GAAP cash flows versus $17 billion in debt Valeant looks like it is going bust. Valeant has asked you to look not at GAAP EPS but at non-GAAP "cash EPS" which is net of one-time charges. If you believe the one-time charge number represents true one-time charges then you believe the Valeant story. If however ordinary expenses are put in the one-time charge number then you do not believe the "cash EPS number".

Here is Mr Pearson, from yesterday talking about how the acquisition team might not be able to do many acquisitions whilst they are awaiting the outcome of the Allergan deal:

Mr Pearson: I think a bit of a silver lining in this in that [Valeant are] not doing any other significant acquisitions at this time, will mean that our financial statements will actually begin to really demonstrate that our one-time costs are really one-time costs. And that you'll begin to see that GAAP and non-GAAP EPS and organic growth. Everyone will see that the business model is working.

It is of course possible that some of the one time charges are in fact one-time and some are in fact ordinary expenses that are misclassified as one-off. In that case the truth lies somewhere between GAAP numbers (large and increasing losses) and the non-GAAP "cash EPS".

Indeed I think that is the likely outcome and was consistent with the conference call. Again I will stick to the Medicis merger.

There were some definite one-time charges. $109.4 million of the expenses on the Medicis merger were to fund layoffs. Even if I were to quibble about redundancies at the edge I would be forced to admit that most of those were mostly indeed one-off. [They did take a lot of redundancies - probably too many as they admitted later in the call.] Adjusting EPS by these one-time charges appears reasonable.

However it appears that I was entirely right about the Scuptura/Galderma royalty as per Post IIIA.

To quote:

Howard Schiller (CFO): And one last assertion that I would like to address relates to royalties on Sculptra. There had been statements that this royalty to Galderma was an obligation that existed when we acquired the product from Sanofi in December 2011 and that we subsequently prepaid this royalty and charged it off as an acquisition-related cost at the time of the Medicis acquisition. The fact is that when we acquired Sculptra from Sanofi, there was no royalty obligation to any third party. In the fall of 2012, Galderma sued to enjoin Valeant's acquisition of Medicis, and Valeant later entered into a settlement with Galderma to allow the acquisition to be completed. The settlement included $15 million in upfront payments and a 5% annual payment on worldwide sales to Sculptra. Because Valeant did not receive any additional rights associated with Restylane, Perlane or Sculptra, both the $15 million upfront payment and the fair value of the future payments of $24.2 million were recorded as acquisition-related costs during the fourth quarter 2012. Of the $24.2 million that was reported, $2.6 million has been paid to date. The royalty obligation will be eliminated upon the sale of the Valeant injectable aesthetics business to Galderma, and the remaining balance will be reversed as a credit to acquisition-related costs at close and will not be included in cash EPS.

Lets read this. Valeant believed that when we bought the product from Sanofi there were no royalty obligations to any third party. Galderma sued and Valeant settled for cash including an up-front payment of $15 million and annual royalties of 5%. Now if there were no royalty obligations then Valeant would not normally settle. [This suggests at a minimum Valeant does not have an adequate patent database and patent lawyers.]

Having settled Valeant charged to one-time expenses $15 million plus $24.2 million for future payments as a legal settlement. The $24.2 million was the present value of future royalties they might have to pay. Now as they sell Sculptura they record as continuing income all sales but the royalties on those sales get netted off the 24.2 million they recorded. This is more or less precisely the suggestion I made. Income goes through the cash-EPS number, and expenses associated with that income go through the one-off charge line.

Moreover they have not yet paid out much of this Sculptura royalty - they still have, on their balance sheet, a liability for over $20 million - the future value of Sculptura royalties. They will cancel that as part of the sale of the aesthetics assets to Galderma. [So now there will be non-cash proceeds of asset sales.]

One cockroach, how many more?

The excess redundancies at Medicis

Mike Pearson admitted in the conference call that redundancies in the sales force at Medicis were inappropriate. Talking about potential redundancies at Allergan:

Mike Pearson: We plan to keep -- one thing that we've learned in the Medicis and B+L acquisitions is don't touch the sales force, right? I think in Medicis, we did touch the sales force, and that was problematic for a period of time. Our sales force in dermatology now has been stable for a few quarters, and quite frankly, all of our promoted products in dermatology are growing. And so that was a lesson we learned.

This completely matches your intuition (if they sack roughly 100 percent of the staff with an acquired company they will sack sales staff and the sales will go down). It also matches the scuttlebutt I have heard (the Medicis acquisition was a mess with respect to sales and contact with dermatologists). However it is contrary to previous comments by Mike Pearson.

In the first quarter 2013 conference call they told us these brands were doing great (that is just after they sacked the sales force):

Mike Pearson: ...Again, the Medicis brands that -- let me go through againat some portion. You don't have a slide to take a look at, but as I go to the Medicis brands, Ziana and Solodyn are both performing at expectation. Zyclara is a little bit behind and the Dysport, Restylane and Perlane, which are the aesthetics brands are performing ahead of expectations. In terms of what's happening in the marketplace, pricing is largely staying the same. We did take a price increase on Restylane in the first quarter of about 10%.

In the second quarter of 2013 the products were doing great too:

Mike Pearson: I am pleased to report that our aesthetics franchise has its best quarter since Medicis launched its aesthetic products. In particular, Dysport had its best quarter ever and gained significant market share against BOTOX and Xeomin.

They were doing great as late as the first quarter of 2014.

Mike Pearson: In aesthetics, I know there were some comments based on some survey in terms of our share. Our injectable sales, which would include Dysport and our fillers in the first quarter in the United States, grew 15%. I think I heard somewhere that it was cited the market grew at 11%. So I'm not familiar with that survey, but that would suggest we're gaining share, not losing shares. So we had very strong performance on the aesthetics side, continuous strong performance.

These are again the Medicis products.

Mike Pearson then adds:

And that's before the impact of the extra 100 people we have now hired.

This is the sales force that was originally fired being replaced. They really did need to rehire a dermatology sales force.

This is strange. Sales were great and increased market share every quarter after the Medicis acquisition but Mike Pearson admits that it was a mistake to touch the sales force and they needed to rehire sales people.

I have tried and tried to square the circle but I can't. There remains one tantalizing possibility - and that is that they simply changed the definition of a sale (and hence reported growth where there was none). This is somewhat supported by SEC filings. The 2013 Form 10-K discloses:

In 2012, consistent with legacy Medicis’ historical approach, we recognized revenue on those products upon shipment from McKesson, our primary U.S. distributor of aesthetics products, to physicians. As part of our integration efforts, we implemented new strategies and business practices in the first quarter of 2013, particularly as they relate to rebate and discount programs for these aesthetics products. As a result of these changes, the criteria for revenue recognition are achieved upon shipment of these products to McKesson, and, therefore, we began, in the first quarter of 2013, recognizing revenue upon shipment of these products to McKesson.

This is such a bold change in revenue recognition that it raised questions from the SEC who asked Valeant about it in formal letters (filed on the SEC site). The question asked is below:

SEC Question: You disclose that you changed the revenue recognition procedure for several brands acquired in your business combination with Medicis to now recognize this revenue upon shipment to your distributor instead of when this distributor ships products to physicians. Please provide us your analysis supporting this change in revenue recognition. In your response, please tell us why management of Medicis delayed recognition and what has changed, including what additional information you have, to permit you to recognize revenue for these products earlier than under Medicis’ policy.

You can find the question and answer provided by the company at this link. For students of revenue-recognition accounting the answer is flat funny (disguised in turgid prose).

Anyway, it seems they reported market share growth in part by changing the definition of sales.

And then they hope to solve that problem long term by hiring 100 sales people to replace the ones they fired.

John

Finally I should note that I am going to Europe mostly to meet with companies that we are invested in or might invest in. We are also meeting some clients. The frequency of posts on Valeant and other matters is likely to slow down.

30 comments:

I've been following this series with great interest - I think your discussion of the change in revenue recognition is a palpable hit.

But it leads to some (probably stupid) questions. What is the shelf life of this stuff, and what is the returns policy in this market? If the distributor can't move the inventory ... what happens in this industry? Who cops the charge?

1) That method of revenue recognition is standard across the drug industry. What's more, according to the 10-K it related to just Perlane, Restylane, and Dysport, which were about 1/3 of MRX sales (~$250M) at the time of acquisition. McKesson's total Days on Hand for 2013/2014 is approximately 35 days, so the upper bound of the benefit is +~$24M (35/365*$250) on last year's reported revenue of $5.6B. Also, in the first quarter, when presumably most of this benefit would've occurred, VRX reduced the inventory in the channel by ~1 month, or ~$24M dollars. There's a discussion on their 1Q13 conference call, as well as in the 8-K filed with the earnings release. So at best, their aggressive accounting simply offset their business decision to keep less inventory in the channel.

2) On the Galderma royalties, I realize this might just be a general point of disagreement, but the royalty didn't come on the purchase from Sanofi. It came as a consequence of VRX purchasing MRX, so it probably isn't unreasonable to include that as a cost of the MRX deal. As for their practice of crediting the royalties against the liability, they mentioned on the call yesterday that they've so far done that with $2.6M. That's against VRX's cumulative reported 'cash net income' since the MRX acq (4Q12-1Q14) of >$3.0 Billion. It's hard to see how this rises to the threshold of materiality in that context. Now I'm sure you would retort with a slippery slope argument and those are of course impossible to dismiss and the whole reason that this debate exists in the first place. And I realize there is never any 'smoking gun', but both of these seem immaterial on a stand-alone basis.

John, please, check your facts. From the correspondence with SEC that you quote yourself:"To date, the Company has not received any requests from McKesson for the continuation of the consumer rebate programs or any negative feedback from the market due to the lack of consumer rebate programs or discounts. Further, there has been no instance where the Company provided concessions to McKesson (including accepting returns from McKesson beyond the contractual requirement to accept defective products), nor does the Company have the intention to do so, due to this change in business practices. There is no general right of returns under theagreement with McKesson."

John, here're the first 2 sentences of AGN's revenue recognition note from their most recent 10-K:

We recognize revenue from product sales when goods are shipped and title and risk of loss transfer to our customers. A substantial portion of our revenue is generated by the sale of specialty pharmaceutical products (primarily eye care pharmaceuticals and skin care and other products) to wholesalers within the United States, and we have a policy to attempt to maintain average U.S. wholesaler inventory levels at an amount less than eight weeks of our net sales.

Note the language "a substantial portion of our revenue is generated by the sale of spec pharma products TO wholesalers." They go on to note that management attempts to manage the inventory in the channel to 8 weeks. I'm not sure why anyone at the SEC would care about this unless AGN is in fact recognizing revenue upon shipment TO distributors rather than upon shipment FROM distributors.

Finally they note that breast implants are sold on a consignment basis, and the note reads as though that is the only inventory sold on consignment.

Maybe I'm misreading, but it certainly appears that AGN employs the exact same method of revenue recognition.

MB - why do you insist on misquoting to the point of LYING. They also specifically state that they recognize revenue when TITLE shifts.

And later in the same filing they note that title does not shift in the case of transfer to wholesalers - specifically stating that the wholesalers have a right of return. Indeed they go further...

"We permit returns of product from most product lines by any class of customer if such product is returned in a timely manner, in good condition and from normal distribution channels. Return policies in certain international markets and for certain medical device products, primarily breast implants, provide for more stringent guidelines in accordance with the terms of contractual agreements with customers. Our estimates for sales returns are based upon the historical patterns of product returns matched against sales, and management's evaluation of specific factors that may increase the risk of product returns."

John Do you understand there is a difference between dermatology and aesthetics? Some of the Medicis products were derm, some aesthatics, and they have had divergent paths.

The derm business had some weak spots progressing through 2013 (zovirax and solodyn especially). Derm is the business where they really disrupted the salesforce during integration.

The aesthetics business on the other hand was very strong in 2013. In this business they largely kept the medicis salesforce intact. This is also the business where they planned to add 100 reps in 2014 (not derm) to try to accelerate growth even more. I guess you could interpret this as cutting, then adding back, but given that a year elapsed I view it as just a commercial decision to make an organic investment based on facts on the ground.

In Mike's quotes the distinction between Derm and Aesthetics is not always conveyed, but I interpret them as consistent with the facts as laid out above.

I view the rev rec change, the lawsuit-driven royalty classified as restructuring, and everything else you've pointed out on this blog as red herrings. Remember that the earnings power ex intangible amortization (leaving aside restructuring) has been growing in dollars not pennies...

Pearson tends to be unclear what he’s referring to when he says “derm”. There is aesthetic derm (Dysport, Restylane, Perlane) and there is therapeutic derm (Solodyn, Ziana, Zyclara, Zovirax). Pearson contends that aesthetic derm did well in 2013 and we know that therapeutic derm shrunk due to generic competition and Solodyn declines in 2013. Now, VRX doesn’t disclose sales for either group of products, so it’s always hard for us to track sales of any of these products (IMS doesn’t do a good job either). Pearson has contended that the aesthetic derm products took market share in 2013 from Allergan and that the basket of products grew 30% in revenue terms (this is what I remember him saying from my notes and this is vs pro-forma 2012 if MRX deal had been in effect). We know for a fact that VRX raised price on Dysport by 15-20% (it had always been a 20% discount to Botox before) and that he raised price on the fillers too. I’m skeptical that VRX took unit volume share from AGN at the same time they raised price and there is no proof VRX took revenue share either – but I buy that the business grew solidly. Pearson’s claims for aesthetic derm have been consistent since the MRX deal closed.

Now therapeutic derm is a different story. Zovirax faced unexpected generic competition early in 2013 AND VRX was not able to reverse the declining trend in Solodyn (according to Pearson’s comments). Quoting from 3q13 call, “Solodyn, while seeing some erosion this year, appears to have stabilized at roughly $200M”. This is a product that did something like $275M in 2012. We have 1 business that mgmt. claims grew nicely and 1 that admittedly declined.

I don’t think the performance of either derm business (as claimed by Pearson) is inconsistent with VRX screwing up the MRX integration to some degree. They admit they shouldn’t have cut anyone in aesthetic derm and this is where they planned to add 100 new people (from 90 prior level). Aesthetic derm is very high touch with Docs and VRX did not do a good job reaching out to Docs after MRX closed. But the price increases in the aesthetic business, the improving economy, and improved outreach to docs starting in 2q13 helped the business grow in 2013. So, yes sales grew in 2013, but it was also a mistake to fire aesthetic derm sales reps because the opportunity was there to sell even more product. From my discussion with VRX, they said they had 90 aesthetic reps doing avg $2.5M sales each. These numbers suggest that adding more reps would be a good decision.

You are right that VRX changed revenue recognition policy for MRX AND they also reduced wholesaler inventory of MRX products by 1 month. If the wholesaler holds 1 month inventory and VRX starts recognizing revenue when they ship to wholesaler instead of when the wholesaler ships, then it seems like they could recognize an extra 1 month of sales. But if they also reduced inventory at wholesalers by 1 month then maybe these 2 changes aren’t an exact wash, but seem like it could be pretty close. If I’m wrong in this interpretation, please correct me. You know accounting better than I do. I don’t have enough knowledge to comment on whether the revenue recognition policy is different form most pharmaco’s. I guess I'd worry about this is returns were common

You may not buy these explanations but the claims by mgmt. are not inconsistent here. I’ll admit where I was wrong and you were right – VRX did book a liability for the Sculptra royalty. That is sneaky.

It's as though Hempton has never ACTUALLY worked in accounting or finance...oh wait...

As MB has stated, this method of revenue recognition is extremely standard across the industry. Merely having the right of return has nothing to do with whether or not you can book sales to distributors/wholesalers. The actual accounting question is whether or not the company's auditors believe the company can reasonably estimate returns and has a history of accurately estimating such returns.

Cursory survey of specialty biotechs shows:

GILD 10-K:We recognize revenues from product sales when there is persuasive evidence that an arrangement exists, delivery to the customer has occurred, the price is fixed or determinable and collectability is reasonably assured. We record estimated reductions to revenues for government rebates such as Medicaid reimbursements, customer incentives such as cash discounts for prompt payment, distributor fees and expected returns of expired products. These estimates are deducted from gross product sales at the time such revenues are recognized.

CELG 10-K:Revenue from the sale of products is recognized when title and risk of loss of the product is transferred to the customer and the sales price is fixed and determinable. Provisions for discounts, early payments, rebates, sales returns and distributor chargebacks under terms customary in the industry are provided for in the same period the related sales are recorded. We record estimated reductions to revenue for volume-based discounts and rebates at the time of the initial sale.

BIIB 10-K:As a result of our acquisition of TYSABRI rights from Elan on April 2, 2013, we began recognizing sales of TYSABRI in the U.S. when title and risk of loss passed to the same third party distributor. The timing of distributor orders and shipments can cause variability in earnings.

We establish reserves for trade term discounts, wholesaler incentives, Medicaid and managed care rebates, VA and PHS discounts, product returns and other governmental discounts or applicable allowances associated with the implementation of pricing actions in certain of international markets in which we operate. These reserves are based on estimates of the amounts earned or to be claimed on the related sales.

Revenue from product sales is recognized when persuasive evidence of an arrangement exists, title to product and associated risk of loss have passed to the customer, the price is fixed or determinable, collection from the customer is reasonably assured, we have no further performance obligations, and returns can be reasonably estimated . We record revenue from product sales upon delivery to our distributors and specialty pharmacies (collectively, our customers).

AMGN 10-K:Sales of our products are recognized when shipped and title and risk of loss have passed . Product sales are recorded net of accruals for estimated rebates, wholesaler chargebacks, discounts and other deductions (collectively “sales deductions”) and returns.

1) "That method of revenue recognition is very unusual. The distributor has a right of return."The revenue recognition policies are consistent between the two companies and the rest of pharma. MB wasn't LYING [your emphasis, not mine]. Revenue is recognized upon shipment and then reserved for returns. Sounds like you're being intellectually dishonest when presented with facts that disprove your thesis but you don’t admit you’re wrong. See below.

2) You start swearing in this post which means you're on tilt. Sweet! Can we play poker some time?

"PD. Please check your facts. McKesson is a 5% gross margin, 3% net margin business that holds and distributes products (pharma) with a 70% gross margin. It is incredibly valuable for a pharma company to make sure that McKesson has enough inventory - so they overload and ALWAYS give a right of return. The maths of this comparison makes it really obvious that VRX's claim is bullshit."

3) To reiterate the point that MB was making, the likely upper bound of the benefit by shifting the revenue recognition policy is likely $20mm but was offset by the reduction of inventory in the channel by 1 month. Given that wholesalers often hold inventories for 1 month, the benefit to VRX was likely $0 in the quarter. I think that MB did a great job of illustrating that point with math. As will I. See below.

4) "Sales decreased, Pearson admits as much when it was a mistake to touch the sales force". You sure about that one? What is knowable is that 18 months post the acquisition of MRX, they sold the fillers/toxins business for $1.4bn with $500mm of MRX sales left over even though Solodyn was crap. Galderma's actions speak louder than your words.

5) Yes you were right on the Sculptura royalty!!!!! To the tune of $2.4mm over 18 months on a cumulative $7.6bn of revenue. However, given that the royalty was triggered because of the acquisition and wouldn't have been obligated to pay without the transaction, they were within the letter, if not the spirit, of the law.

1) “That method of revenue recognition is very unusual. The distributor has a right of return.”

Both VRX and AGN recognize revenue when title shifts and shipment to the wholesaler. Even though the wholesaler has the right to return, neither VRX nor AGN are precluded to book the revenue on distributor receipt. This is very "usual". Again, feel free to read the revenue recognition of both in more depth:

VRX:We recognize product sales revenue when title has transferred to the customer and the customer has assumed the risks and rewards of ownership, the timing of which is based on the specific contractual terms with each customer. In most instances, transfer of title as well as the risks and rewards of ownership occurs upon delivery of the product to the customer. Revenue from product sales is recognized net of provisions for estimated cash discounts, allowances, returns, rebates, and chargebacks, as well as distribution fees paid to certain of our wholesale customers. We establish these provisions concurrently with the recognition of product sales revenue.

AGN:We recognize revenue from product sales when goods are shipped and title and risk of loss transfer to our customers. A substantial portion of our revenue is generated by the sale of specialty pharmaceutical products (primarily eye care pharmaceuticals and skin care and other products) to wholesalers within the United States, and we have a policy to attempt to maintain average U.S. wholesaler inventory levels at an amount less than eight weeks of our net sales.

Shall I continue with the AGN 10K? I think I shall:Estimated allowances for sales returns are based upon the Company’s historical patterns of product returns matched against sales, and management’s evaluation of specific factors that may increase the risk of product returns. The amount of allowances for sales returns recognized in the Company’s consolidated balance sheets at December 31, 2013 and 2012 were $84.4 million and $77.9 million, respectively, and are recorded in “Other accrued expenses” and “Trade receivables, net” in the Company’s consolidated balance sheets. (See Note 5, “Composition of Certain Financial Statement Captions.”) Actual historical allowances for cash discounts and product returns have been consistent with the amounts reserved or accrued.

So, the distributor has the right of return and it is up to the pharma company to reserve for that but doesn't prevent the pharma company from booking the revenue.

Part III:Maybe rather getting lost in the pedantry of the 10Ks we can look at some real-life examples on why the accounting is not "unusual".

Firstly, given the depth of your expertise in accounting, wouldn't you concede that the fact that all wholesalers around the world taking billions of dollars of inventory and corresponding payables onto their balance sheet as proof that they are liable for the goods when shipped to the warehouse? You need not look any farther to the "bulk" revenue that a distributor recognizes to further prove the point. Even though the goods only pass through the distribution facility for a short time on the way to a large customer, the distributor books the revenue/costs. See Cardinal Health's accounting issues from last decade. That may illuminate the "usualness" of the accounting treatment.

To continue, if the revenue was not recognizable upon shipment and title transfer to the wholesaler, why would they have all that working capital tied up and such huge revenue lines ($300bn between the big 3 US wholesalers)? MCK has $27bn of inventory + AR tied up for $2-3bn of net income. I would bet that a distribution CFO would argue quite vehemently that the capital is real and they are liable for things that are shipped to them.

If that isn't enough of an answer – we can go back to the pharma channel stuffing blow ups of early last decade. Bristol Myers was one of the most prominent. If Bristol was only able to recognize revenue upon shipment to end customers and not the distributor, you would have seen DIH and payables blow out at the retailers. Also worth mentioning it is harder to stuff 60k pharmacies with product than it is 3 drug wholesalers. The numbers will show that the distributor balance sheets were getting bloated and the pharmacies were not.

Now, a pharma company needs to adequately reserve for returns and breakage just like every manufacturer out there. Even though the pharma company can return the good, doesn't mean the sale isn't bookable. That, my friend, is "usual". Just like when you go to the store and buy a piece of clothing. You can return it in many cases but you don't have the retailer calling you to ask if you wanted to keep wearing the shirt so that they can book the revenue - no they book the sale and guess how many people are going to return it. Given shelf life of multiple years for most pharmaceuticals and days inventory on hand in <1 month, the drugs are not likely to spoil. (you can get shelf life by reading the label of any drug).

A long winded way of saying that the "usual" way of accounting is the way that VRX changed MRX to as well. So MRX was the outlier, not VRX.

Let’s take a history lesson: McKesson is actually a 2.5-3.0% gross margin and 150-200bp operating margin business on the drug wholesale side. Feel free to read ABC's 10K and investor presentations to educate yourself. I use ABC because it is a pure play distributor But I pick nits and digress...onward with the lesson.

Many years ago (about 10) the drug wholesale business changed dramatically such that drug companies were no longer able to stuff the distributors with inventory after BMY and others blew up stuffing the channel. In 2002, ABC's days inventory was ~50. Today they hold about 26 days. CAH and MCK's inventory days declined similarly. The wholesalers realized they were making a profit on the excess inventory held but a terrible return on capital. What happened is all the branded pharma companies signed fee-for-service agreements with the wholesalers to change the compensation structure and lower days inventory in the channel. It was an exercise in ROIC. EBIT margins went lower (ABCs were 140bps last year versus 202bps in 2002) but balance sheet efficiency went way up. Use your CapIQ to calcuate the ROIC improvement at ABC over the years or just look at share count/cash flow statement. (I can tell you, ABC's ROIC almost tripled from 9% in 2002 to ~25% last year.)

So, yes you're technically right that pharma has every incentive to jam the wholesalers with inventory given the differential in margins. However, the desire on the part of the wholesalers to maximize returns on capital discourages them from playing that game. The maths prove that out.

I think that most people would agree that the point you made to prove VRX's claim being bullshit is really wrong

3) Maths behind 1Q13:Valeant reduced dermatology inventory in the channel by one month from two. The distributors hold about a month’s worth of inventory which means the timing of revenue recognition pulled forward about a month’s worth of inventory. So, assuming they only reduced filler/toxin inventory by one month and not all of the company’s inventory by one month, the net effect on the P&L is zero: +1-1=0.

Coincidentally enough, going from 2 months to one month when harmonizing MRX’s inventory channel put VRX in the same area as the rest of pharma in terms of inventory in the channel (again, wholesalers hold about a month of inventory).

While they don't have the "right" of return, few and far between are the drug companies who would refuse a legitimate return from McKesson.

The impact of any change in rev rec is always temporary and will correct over the course of a year. This change would have a couple of knock on impacts though in that inventory would go down (one time, by amt held at distributor) and sales would go up by that same amount. Also it means they would move from being net of actual returns to estimating returns as an offset to revenues.

Check out this article for a layman's explanation on how Valeant inflates their pro-forma earnings by excluding amortization of definite lived intangible assets like patents:http://seekingalpha.com/article/2231473-valeant-poor-earnings-quality-masked-by-acquisition-related-pro-forma-reporting

There are a few things asserted that don't add up to me. The language of the 10-K suggests that inventory in the channel is stable (regular deliveries, negligible timing effects at the period edges).

Then either the revenue change was accounted for retrospectively -- in that case Q1 '13 Rev takes a hit from the channel inventory reduction [0 - 1 = -1] -- or it was done prospectively and Q1 '13 Rev simply picks up all the Rev from the inventory in the channel at the end of the quarter [~1=+1, or if you like, 2 mos beg inventory - 1 month Q1 draw-down =+1].

I don't see the scenario in which the changes net against each other in Q1. In addition, following Q1, I would anticipate that any increases in sell-through sales would be amplified on a quarter-over-quarter basis by a factor of ~4/3 in the revenue numbers due to increased inventory stocking.

Then there is this statement in the 2013 10-K: "Consistent with industry practice, we generally allow customers to return product within a specified period before and after its expiration date, excluding our European businesses which generally do not carry a right of return." Contrast this with the SEC correspondence, which as I read it basically says 'we will stop competing on price, or offering rebates, but collectibility is assured because only defective products can be returned from the wholesaler.'

Just wanted to add this comment on Pearson from the notes of Sequoia's investor day in 2011: "if he buys a company he can cut R&D and reduce SG&A without undermining the company’s competitive advantages. Say Valeant acquires a company that has products in Poland; he may well take those products and put them through his existing sales pipeline and get rid of the Polish sales force of the acquired company."

I’ll just add that there are some sectors or industries where we historically have not had large investments, and pharmaceuticals or healthcare is one of them. We did own some Johnson & Johnson in the mid-90s and at that time J&J actually had a highly productive lab in Belgium, which it had acquired from Janssen in 1962. Dr. Janssen ran that lab for a long time and it came up with one after another niche drug. No single drug was large in revenues, but there were enough drugs in these niches that in aggregate they were highly profitable. Then J&J came up with some big blockbusters. One was erythropoietin, which it had licensed to market from Amgen and they subsequently wound up suing each other. Risperdal was the second. Subsequently, J&J ran into the problem of the law of large numbers — Risperdal and erythropoietin were such huge successes that replicating them was very difficult. Dr. Janssen died and that lab is no longer as productive; so subsequently J&J has become primarily reliant on either licensing or acquisitions to fill its pipeline; and that’s a less profitable model.

I’ve seen a figure for the pharmaceutical industry. I think it was a ten-year period but I’m not certain of that. The aggregate return on investment of all R&D for the pharmaceutical industry was 7.5%. That is just far below Valeant’s hurdle rate and below ours. So if we were going to own a pharmaceutical company, especially in size, it would most likely be an unconventional company. Valeant certainly fits that bill.

I'm confused; how do you take a one-time expense for future royalties AND put the same number on BS. If it went on BS it sounds like the liability balance is being reduced each year by actual royalties paid...which seems ok to me...but still not clear how it can simultaneously be expensed at once.

Have you ever tried to follow the footnotes to tables VRX gives in its earnings releases when it reconciles from GAAP to Cash EPS? I was looking through the 4Q2013 press release, table 2 and it shows VRX adding back $1,957mm in "Amortization and impairments of finite-lived intangible assets and other non-GAAP charges" and leads you to look at footnote i. Footnote i says to look at footnote c to Tables 2a and 2b. The problem is that footnote c to Tables 2a and 2b refer you to notes on COGS and don't address the $2bn add back. They also do this for Legal settlements and related fees on Table 2 but that is only for $220mm. Just seems strange that there is no commentary on the largest add back. Wondering if you have seen this and if so, if you resolved it.

Am still following VRX and am still less than clear about what will change the perception of it in the market. This seems to me to be still very much a sentiment-driven stock, with the recent talk of the inherent advantage of "platforms" being secret saucery of a fairly high order. If I had to guess (which I don't, since the market doesn't force you to do anything), I'd say that it grows until it has definitive 900-lb gorilla status, which to my mind is an equity market cap of over 100 billion USD. Then: some writedown (a la Enron) which receives higher-than-usual scrutiny; a pushback on price increases and accompanying muckraking, a surprise resignation, a retrenchment and the question about whether it's a house of cards returning to the fore but with a new urgency.

Will any of this happen? I have no idea. It seems plausible, but most plausible things never occur. If it does happen, when? Again, no idea. But I'll start a pay-attention watch when it hits $100 billion in market cap, especially if that falls early in a year with bonus-triggering 15% returns (or whatever the marks are) needed ahead.

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